20 years of accurate predictions on China and the world economy
实事求是 - seek truth from facts, Chinese saying originally from the Han dynasty

15 August 2014

How China can maintain its economic growth

Earlier this year sections of the Western media tried to spin a story that the world economy was experiencing 'severe slowdown in China' and 'strong recovery in the U.S.' – China's economy was allegedly in trouble and the U.S.'s doing well.

Now that the actual data is in for the first half of the year, it shows that the opposite was true. China's economic growth rate was 7.5% in the year to the second quarter of 2014, and the U.S.'s economic growth rate was 2.4% - China's economy grew more than three times as fast as that of the U.S.

Still more significantly for the U.S., its own statistical agencies and the IMF have officially revised their projections for long term US growth down – both organizations now estimate it at only 2%. The Economist, somewhat cruelly, put a cartoon of the US as a tortoise on its front cover, stating bluntly that U.S. 'long term growth has slowed.'

My calculations for the U.S. economy are marginally more optimistic. Over the last 20 years, U.S. average annual growth was 2.4%, and there is no short term reason why it should slow. But this is just a minor detail, since either estimate means the US will remain on a path of 2-3% annual growth.

What are the comparative prospects for China's economy – not over the next few months, but over the longer term, say to 2020? Answering this requires going beyond immediate news events and short term fluctuations, to the fundamental factors determining China's economic development.

Right at the beginning, it should be clarified that the medium/long term aim of China's policy is not to maximize GDP growth. This is explicit; indeed, it has become commonplace in China recently to say that what matters is not the quantity of growth, but its quality.

But unless it is specified what the criteria for 'quality' are and how 'quality' is to be measured, this becomes an empty, clichéd phrase, of the type China's President Xi Jinping stressed must be avoided. The only correct measure of 'quality' can be the overall well-being and national security of China's population, summarized by China's goal of 'comprehensive national renewal.'

This correctly contextualizes economic growth. Economic growth is not an end in itself, but is an absolutely indispensable means to achieve the desired ends. International comparisons show more than 80% of consumption growth, and over 70% of life expectancy extension – the latter reflecting factors such as health care and environmental quality – is the result of economic growth.

For those at the bottom of the income ladder, economic growth is particularly crucial. The Oxford Poverty and Human Development Initiative recently studied every country in the world's correlation between GDP per person and the Multidimensional Poverty Index (MPI), which considers ten indicators including nutrition, child mortality, and years of schooling. An extraordinarily close correlation was found – as The Economist magazine noted: 'Economic growth may thus not only be the best way to overcome extreme poverty, but also to reduce terrible non-economic social ailments as well.'

Since the attainment of a high standard of living – which requires high consumption, good environment, quality health care, and poverty elimination – is certainly at the top of the priority list if China is to maintain rapid overall progress, sustained high economic growth is indispensable. Fortunately, examination of economic fundamentals shows that, provided no major policy mistakes are made, China will continue to outperform all other major economies for a prolonged period.

Any economy's growth is necessarily determined by two simple ratios. The first is the percentage of the economy that is invested. Modern economic research shows that 57% of growth in an advanced economy is due to capital investment, 32% to increases in labour, and only 11% due to productivity increases (technically known as Total Factor Productivity – TFP).

Developing economies, such as China, at present have the advantage that they can apply technologies from more advanced economies without having to pay the research costs of developing them – a benefit known as 'catch-up.' In developing Asian economies, for example, 22% of growth is due to productivity increases compared to only 11% in developed economies, as the chart below shows.

But the advantage of being able to borrow technology without paying development costs disappears as an economy becomes more advanced. Therefore, the role played by productivity growth falls as an economy moves to higher income levels, while the role played by capital investment increases, as is also shown in the chart above. The percentage of growth accounted for by productivity declines from 19-22% in developing economies to 11% in advanced ones.

By 2020 China will be on the verge of becoming a 'high income' economy according to World Bank criteria. As China is no longer exempt from the economic growth rules that apply to any other country, its growth strategy must therefore assume that as it becomes more developed, its growth will become more and more dependent on capital investment and less dependent on productivity increases.

China's advantage in meeting this challenge is that its investment level, 47% of GDP, is the highest of any major economy, providing a solid basis for long term growth. Maintaining such a high level of investment is the first essential for China's rapid growth, while reduction in investment would affect growth negatively.

The second key ratio determining economic growth is 'how much bang you get for a buck' from investment. Technically this is known as ICOR (incremental capital output ratio): what percentage of GDP has to be invested to generate 1% GDP growth.

So far China's situation is also satisfactory in this respect. Taking the average for the latest three years for which there is data in order to avoid distortions caused by short term fluctuations, China invested 5.1% of GDP for each 1% rise in economic growth, whereas the U.S. had to invest 7.9% – China's investment was therefore about 50% more efficient that the U.S's investment. But China's investment efficiency has fallen – the gap used to be bigger. It is also striking factually that as China’s state investment has been held back, and therefore private investment has risen as a percentage of total investment, China’ ICOR has worsened – that is its overall efficiency of investment has declined.

A key reason is the slowdown in China's industrial growth. Productivity increases in services are much slower than in industry in all countries. But in the last three years China's industrial growth has significantly decelerated to around 9% a year, as shown in the following chart.

It is too early in China's development for it to shift from a manufacturing to a service-based economy. By comparison, South Korea is still an economy dominated by manufacturing, but China's per capita GDP is only one quarter to one third of South Korea's, depending on the measure used. A premature shift from industry to services would therefore lead to a significant decline in China's economic efficiency.

So far the problem is not serious – 9% industrial growth is sufficient to achieve China's 7.5% GDP growth target. But any further industrial deceleration would be damaging, as productivity growth in services cannot substitute for productivity growth in the manufacturing industry.

Maintaining the competitiveness of China's industry will therefore be the key to maintaining China's overall economic efficiency and growth in the coming years.

* * *

This is an update and expanded version of an article originally published at China.org.cn.